The Party Is Over For Supreme Industries, Inc.

| About: Supreme Industries, (STS)

Summary

STS reported a massive, unexpected Q3 backlog decline of 22% yoy. We believe this signals an earnings peak for the company.

The glut in used trucks appears to be finally having an impact on their business. The used truck market may remain oversupplied for up to four years.

Margins are also nearing peak post a restructuring and margin improvements will be more difficult going forward.

We now anticipate Q4 revenue and earnings to decline on a yoy basis. 2017 earnings look to be flattish at best.

STS is trading over 8x peak EBITDA vs a historical average of 6.65x. We expected approximately 40% downside to shares before this morning's slide. 20% or more downside remains.

We are pleased to announce a "flash alert" short thesis on Supreme Industries, Inc. (NYSEMKT:STS). Before this morning's move, STS was overvalued by approximately 40% and still remains approximately 20% overvalued.

Summary:

We have been working on this report for some time now and had considered releasing it on Monday of this week but decided against doing so in front of Thursday's earnings release. We were anticipating a strong third quarter and that's just what Supreme Industries has delivered. We also expected a somewhat soft Q3 backlog. The magnitude of the Q3 backlog weakness caught us off guard though. Backlog of $58.1mil was down 22% year-over-year (yoy) and substantially weaker than we anticipated.

Initially we felt STS was a short based upon valuation, heavy insider selling, and near peak margins & earnings in the midst of what amounts to the middle of a recession in the rest of the trucking industry. Our call was that while STS had escaped the decline that the rest of the trucking industry is currently undergoing, at some point in the not-to-distant future it would also catch up to STS. Today appears to be that day. Initially we felt STS could continue growing, albeit at a far slower rate, in 2017. Based on the new backlog data and management's comments we now believe Q4 earnings will be down yoy. We also believe 2017 earnings will likely be flattish vs. 2016 and possibly down. STS was expensive before. Now it looks like valuation is off the charts.

The stock has been up close to 170% this year and volume has been much higher than in previous years. A stock that historically traded less than 10k shares a day less than a year ago is regularly trading 3, 4, 500k shares per day in 2016. One day in June of this year it traded over 1.3mil shares. We believe that there are a couple of factors that have pushed STS into nosebleed territory outside of improved earnings. It appears that investors have discovered STS after many years in obscurity. In an economic environment with anemic growth, STS has stood out as company with high growth in the right place at the right time.

The vast majority of the trucking industry is seeing very difficult times that started in mid 2015. Most of the slowdown has impacted the Class 8 heavy-duty tractor market. STS isn't in the Class 8 market. They make truck bodies for light and medium-duty trucks, or the Class 2-7 market. Body types include cutaway van bodies, Spartan service bodies, cargo van bodies, refrigerated (reefer) insulated bodies, stake bodies and box truck bodies. On the truck bodies they often install liftgates, cargo-handling equipment, customized doors, bumpers, ladder racks and other equipment. They also make specialty vehicles including armored vehicles. Major customers include Ryder (NYSE:R), Penske and Budget.

Source: supremecorp.com

This portion of the industry has been far stronger than Class 8, driven by increasing leasing trends and local delivery. Additionally STS has benefited from expanding margins post a restructuring and low return asset disposal that wrapped-up in early 2014. Since then margins and earnings have been on the rise and had really caught fire in just the past couple of quarters. STS also has been growing its sales force. This has led to further improvements in revenue as sales reps have been ramping over the past couple of years. This year STS is set to post all-time record earnings near $1.18 per share vs. $.76c in 2015.

Our guess is that transportation investors have recently been hiding out in STS. On the surface it made sense, especially if you got in back in February. While the rest of the transports are suffering with little or negative growth, STS has seen explosive earnings growth over the past year approaching 100% in the past couple quarters in a seemingly insulated category. There aren't many other pure play ways to invest in the medium-duty truck market either. On top of that they pay a small regular dividend and special dividends on occasion so it's a draw for the dividend investor as well. Of course, most dividend plays are extremely overvalued at this point and we'd also throw STS into that category.

All of these factors appear to have combined to make STS a momentum investors dream: a small-cap company with strong revenue growth, improving margins, explosive earnings growth and a dividend to boot. Couldn't get any better than that, right? That's exactly the problem. STS is now priced for perfection on peak earnings. It's as if suddenly everyone forgot that this is an industrial cyclical company. STS is not a recurring revenue company, they're not a high margin software company and they are not even a consistently growing restaurant. STS is a highly cyclical industrial company with highly cyclical earnings. When it comes to cyclicals, a good rule-of-thumb is that once everything looks like it is going perfectly and the future couldn't look any brighter, that's when you sell. Based on Q3 backlog, it looks like the party's over for STS. Look out below.

Heavy Insider Sales:

You know who didn't forget this an industrial cyclical company? Insiders. Our interest in STS began when we noticed insider selling had become particularly heavy in 2016. It's often said that when an insider buys it's safe to assume they think the stock is cheap but when they sell you can't really know why. It could be that they are selling for tax purposes, diversification or due to personal needs that are unrelated to the stock price. From a surface level that's a fair argument, but if you take a closer look often you can glean more meaningful information.

Having thoroughly reviewed insider sales at STS we're of the opinion that they are selling because they believe the stock is overvalued. Out of the 12 members on the board, 10 have sold shares this year. Of the remaining two that did not sell, one joined the board this year and only has 204 shares. Specifically in 2016 insiders have been heavy sellers of STS in comparison to other years. To date they have sold over 800k shares this year compared to current holdings of 2.9mil shares by board members and executive insiders. That equates to 23% of their holdings since the beginning of the year.

It's also important who sold and what their relationship is to the company. The CEO, CFO and VP of Operations have all sold stock this year. The two largest insider shareholders of STS by far include Chairman Herbert M. Gardner and Executive VP and Secretary William J. Barrett. After selling about 205k shares this year Gardner holds near 909k shares. Barrett has sold over 360k shares in 2016 and currently holds over 1.6mil shares.

Herbert M. Gardner and William J. Barrett have a very long history with STS. In fact, they brought the company public in 1984. At the time both of them were investment bankers at Janney Montgomery Scott in New York. They were looking to make an acquisition with a fully funded shell company when they met Supremes' founder, Omer Kropf. Kropf was a hard working high-school dropout that started Supreme in 1974 and had built the business to $28mil. They bought him out, brought the company public via the shell and started putting the cash to work expanding the business.

Mr. Gardner and Mr. Barrett have been on the board from the very beginning. Mr. Gardner has been Chairman throughout the company's history. They both have extensive, intimate knowledge of the company and the cyclical nature of the business. We believe the sudden increase in stock sales this year says a lot about their current opinion of STS valuation and it's not good if you happen to be long.

Source: SEC Filings & Cliffside Research

In addition to insider sales, the top two largest institutional shareholders have also been selling stock as can be seen in the chart above. Fidelity started the year as a 6.5% holder and has since sold their entire position according to their latest 13F filing. The sales by Fidelity add to the selling trend but we believe the sales by Wilen Investment Management are even more telling. Wilen is a hedge fund with approximately $200mil in AUM run by James R. Wilen. James is a regular contributor to the Q&A portion of STS earnings calls. Recently, Mr. Wilen's fund has increased their selling of STS stock. Mr. Wilen's fund is invested fairly heavily in cyclical industrial corporations and he is on the board of Monro Muffler Brake, Inc. (NASDAQ:MNRO). We feel his selling in conjunction with the other sales outlined above is a strong warning sign that should be heeded.

Source: SEC Filings & Cliffside Research

This Chart Says It All:

If you are an analyst or PM who is advocating ownership of STS stock at these levels we dare you to bring the following chart to your boss and/or investors and explain why you would own STS here. The chart below going back to April 1981 clearly shows a defined pattern of peaks long before an economic cycle enters a recessionary period. It also very clearly shows that STS should be bought during a recession, not mid-to-late cycle.

Source: Google Finance & Cliffside Research

STS always peaks long before a recession can be sniffed out.

We are not in a recession. The economy quite clearly is currently in a mid-cycle period with GDP growth expected to slow going forward according to the Fed. Employment is reaching what is generally considered peak levels and interest rates are expected to be raised going forward despite sluggish growth. Truck sales have slowed and medium-duty truck sales are expected to continue slowing in 2017. STS has already appreciated to its highest level on record by a large margin based on improved earnings post restructuring and disposing of low return assets. Margins are currently at all-time highs. Backlog has peaked and is now in significant decline, down 22% in Q3. The stock is fully reflecting recent sales and margin improvements in our opinion and future gains on both will likely be far more difficult for management to achieve.

We believe earnings have peaked for this cycle based on the recent drop in backlog and management comments. In the just reported Q3, management stated that "industry-wide growth in commercial truck sales decelerated during the summer months, suggesting moderate order activity through year end." We would add that we expect moderate activity to continue into 2017 and perhaps beyond based on our research.

We recently reported that Covenant Transport (NASDAQ:CVTI) management stated on their Q3 call that "nobody is buying new trucks now." There is a glut of used Class 8 trucks in the marketplace and although STS isn't in the Class 8 market, we believe the slowdown in the Class 8 market is finally spilling over into the fairly robust light-duty and medium-duty market that STS services. As used truck values decline, there is less incentive to buy new trucks and this directly impacts STS. CVTI noted that things have really deteriorated in the used truck market in the past 5 months.

Here we provide an excellent article by National Lease, one of the largest truck leasing organizations in North America, describing the current oversupply in the used truck market. In the article they clearly state that the slowdown that started in Class 8 has now moved to the light and medium-duty market where STS competes. Ominously, the article concludes by stating that their assumptions are based on "stability in the economy and freight volumes. If the freight volume or the general economy falters, then used truck prices would be in a position to free-fall." This would not bode well for new truck sales in any category. It also aligns with STS's comments that sales began slowing this summer.

The used truck glut is bringing down used truck valuations and trucking companies will likely be taking down salvage values like CVTI just did this month. The result is higher depreciation expense that is killing trucking operator earnings. CVTI said they believe that as the market wakes up to the level of depreciation they will have to take on their existing fleet, they will stop buying trucks. CVTI also said they expect smaller operators to go into bankruptcy and this will exacerbate the used truck market oversupply issue. So a used truck market that was supposed to be reaching equilibrium by year-end could now be oversupplied for the next 3-4 years as small operators liquidate, according to CVTI. We believe many of the smaller operators may also be owners of medium-duty trucks and this is one way that we may see the spillover effect from Class 8 weakness into the medium and light-duty market.

This sets up for the very worst time to invest in an industrial cyclical like STS. The old saying that investors should buy when "there's blood in the streets" applies doubly for small-cap cyclical stocks. The chart above clearly shows the absolute best time to buy is when economic conditions and earnings are at their worst. The worst time to buy is mid economic cycle where we are now. Unfortunately for many investors there is huge temptation to invest in small-cap industrial cyclical companies at exactly the wrong time and it appears that is what is happening right now.

During an economic downturn, cyclical earnings tend to fall and often small-cap companies like STS will lose money. As the stock gets slaughtered heading into recession, it looks extremely expensive as earnings continually move lower and eventually negative. In periods of recovery when earnings are at their peak, the stock looks cheap with a low PE relative to (historic) growth.

That's exactly how STS looks right now. 75% of the year is in the bag with $.99c in EPS vs. $.76c total for 2015. STS is up 170% year-to-date and appears to fully reflect the improvement. Analysts expect $1.18 for full-year 2016 EPS, which matches our estimate and equates to 55% yoy earnings growth. Based on this estimate STS is currently sporting about a 15x PE multiple and about a .28 PE/G ratio. It appears highly unlikely that the PE/G will improve next year.

The 2017 EPS estimate is $1.32, which equates to 12% earnings growth over the 2016 estimate. We now believe the street estimate will have to come in, perhaps even below 2016. As we stated earlier, our 2017 estimate assumes about flat earnings growth vs. 2016. STS is trading about 13-14x the current 2017 street estimate for a 1.1 PE/G ratio. Even if STS beats this year and comes in closer to say $1.28, that will only set-up a harder comp for STS to overcome in 2017. 2017 was already expected to be a softer year for medium-duty trucks; the outlook has only deteriorated since.

For STS margin improvements will be harder to come by post the 2011-2013 restructuring and disposal of the shuttle bus business. Simply put, peak earnings results are fully reflected in the stock price. History is telling us all we need to know on STS. Insiders and institutional holders with long relationships and extensive knowledge of the company are selling heavily. The alarm bells are sounding. Are you listening?

Backlog Falls Off A Cliff:

Trucking in general has been weak in 2016 stemming from a decline in long-haul freight that we described earlier. This has mainly impacted Class 8 demand while class 2-7 had been holding up far better overall. Class 8 truck orders dropped 28% in September with orders down an average of 40% through the first nine months of 2016 according to ACT Research.

Currently backlog is indicating the slowdown in light and medium-duty is well underway for STS. Q2 backlog was only up 2% yoy and Q3 backlog is now down 22% yoy and 23% sequentially. This doesn't seem to fit with a stock up nearly 170% year-to-date.

Source: SEC Filings & Cliffside Research

To get another perspective on how bad the $58.1mil in backlog for the third quarter really was, we compared revenue to backlog from the prior quarter going back to 2010. Since 2010 revenue has only been higher than the previous quarter's backlog in two quarters: Q2 and Q3 2014. In those quarters revenue was only 2% and 5% higher than backlog from the prior quarter. We are now currently estimating revenue of $65mil for Q4 as can be seen to the far right of the chart below. If STS reaches $65mil in revenue for the 4th quarter they will be 12% above the Q3 backlog. This has never been done as far as we are aware.

Based on our $65mil revenue estimate for Q4, we are currently modeling an earnings DECLINE for Q4 on a yoy basis. For Q4 our current estimate is $.19c per share in continuing operating income vs. $.22c per share last year. We also note that to reach $.19c we are modeling for a gross margin improvement in Q4 to 22% vs. 21.7% yoy despite a revenue estimate that is $2.7mil lower than last year's Q4. It would appear there is downside risk to our revenue and earnings estimates.

Source: SEC Filings & Cliffside Research

Margins Near Peak:

Last quarter's gross margin of 24.1% was an all-time high for STS. At least we believe it was an all-time high as the SEC filings and our model only go back to 1993. At any rate, it's clear their Q2 margin was outstanding. In the company's Q2 quarterly call they said margins were driven by higher retail sales and less fleet sales. In fact, the CFO appeared to slip when he said that fleet was actually down yoy.

This particular quarter had to do with, what you might call favorable mix, we had lower year-over-year fleet business, not that we wanted to be lower, but it has lower gross margins and higher retail business year-over-year.

~Matthew Long, CFO

He then went on to state that, "the low hanging fruit I think has been done and you see that as we've improved the margins again, straight for the last six quarters." With margins at all-time highs post the restructuring and sale of low return assets we believe margin improvements are near, if not at, peak levels. Certainly margin improvements moving forward will be more difficult to achieve according to their own comments. Guidance on gross margins long-term has been to reach 20% sustainably. They appear to have reached this target but for the past few quarters when asked have been reluctant to raise this bar. We anticipated a margin contraction in Q3 and they did, to 23% on seasonally lower revenue. Q4 Margins will also likely contract compared to Q2 due to seasonality. STS won't get the same operating leverage on fixed costs as they did in Q2.

Regarding Q2 margins…

We had some serious leverage on our fixed cost with the increased volume as you look at the backlog, the backlog is going to settle more towards the way it looked Q3 last year. So I wouldn't expect the same level of leverage on the fixed costs.

~Matthew Long, CFO

Source: SEC Filings & Cliffside Research

STS Stock Disconnects from Housing Data:

STS often references economic indicators to provide an idea for the current state of business. Management believes certain indicators like housing are important drivers of the business. This is one of their favorite indicators and they reference it often in earnings calls. Historically housing has shown some correlation to the company's stock price as we can see in the chart below. Recently there has been a huge disconnect between STS and the housing data.

This disconnect has been driven by strong margins post the restructuring and improving sales which have driven strong earnings for STS. Now with the 22% decline in backlog it appears STS earnings will see a reversion to the mean. Housing construction growth has been somewhat flat this year while STS stock has taken off, up 170% ytd. The anticipation of a fed rate raise is putting upward pressure on mortgage rates and by extension housing. Mortgage applications were recently down 6% on higher rates. Increased rates may also pressure truck leasing at the margin and that's also been a big driver of sales for STS.

Source: US Census Bureau, Google Finance & Cliffside Research

Currently STS is hitting on all cylinders with improving sales, margins and earnings. The stock has greatly appreciated as a result and that's great news if you bought the stock at $6. We caution investors looking to buy the stock here because historically when buying cyclicals the worst time to buy them is when things couldn't look any better. When a cyclical is hitting on all cylinders and the stock is at all time highs it is often the case that we're nearing a top. This is usually only realized in retrospect at some time, perhaps a year or two into the future. Such is the nature of cyclical stocks. They are extremely counterintuitive. When things couldn't look any worse that's when you buy them. When things look perfect that's when you sell.

Valuation:

(Note: The following valuation was based on Thursday's price in the $17.50-$18 range. Despite the pullback, STS remains approximately 20% overvalued by our estimates.)

Valuation should never be justified based on a peak earnings cycle, especially for industrial cyclical companies. It's important to value them based on average earnings that include trough earnings based on recessionary periods. To simply value STS on what could be peak earnings is to commit a fatal flaw in valuing the company because the good times never last for industrial cyclicals. When the economy finally turns down, they get burned. Considering this we went back through the financials and found that the average annual per share continuing income from operations for STS is $.42c. The average historical P/E is 12.9x earnings. Even assuming that going forward with improved margins the average EPS from continuing operations is two-times the historical average of $.42c, or $.84c, the stock is currently trading nearly 21x average historical earnings with a declining backlog signaling a sales and earnings peak. If we give a 12.9x P/E multiple based on two-times the historical average operating income per share of $.42c we get a stock price of $10.84 per share for downside of approximately 38-40%.

We also valued the company based on historical EV/EBITDA ratios. Historically the average EBITDA has been about $12.7mil and the average EV/EBITDA has been 6.65. Again we generously assume that going forward average EBITDA is two-times the historical average. We arrive at a valuation of $11.17 per share representing approximately 36-38% downside to current valuation.

STS Historical Earnings

Continuing Op. Income/Share

P/E

EBITDA

EV/EBITDA

1993

0.49

11.2

$11,057,775

1994

0.63

9.1

$12,671,172

5.74

1995

0.71

12.1

$15,946,081

6.73

1996

0.44

12.6

$12,455,375

6.57

1997

0.67

13.4

$18,326,891

7.29

1998

0.81

11.9

$21,573,725

6.63

1999

0.71

8.8

$19,149,111

5.89

2000

0.71

4.1

$20,536,192

3.12

2001

0.41

10.2

$14,708,592

4.59

2002

0.30

14.8

$10,845,796

6.06

2003

0.38

16.1

$11,756,667

7.99

2004

0.38

16.8

$10,708,187

10.11

2005

0.65

11.9

$18,965,971

6.82

2006

0.36

17.8

$13,942,435

8.61

2007

0.30

19.7

$12,284,181

8.85

2008

(0.15)

N/A

$1,338,601

N/A

2009

(0.40)

N/A

$(4,222,817)

N/A

2010

(0.60)

N/A

$(3,038,915)

N/A

2011

0.11

25.0

$6,436,897

8.15

2012

0.73

4.4

$15,415,647

4.11

2013

0.68

15.2

$13,323,272

7.56

2014

0.51

14.0

$16,437,801

6.88

2015

0.76

9.1

$22,567,929

4.66

Average

0.42

12.9

$12,747,242

6.65

2016

1.18E

14.8

34,675,392

8.13

Source: SEC Filings & Cliffside Research

STS Valuation Based on 2x Historical Average Income

P/E Based

2x Avg Cont. Op. Income/Share

$0.84

Historical Average P/E

12.9

Price per Share

$10.84

Downside

38-40%

EV/EBITDA Based

2x Avg EBITDA

$25,494,484

Historical Average EV/EBITDA

6.65

EV (6.65x Historical)

$169,538,319

Cash Net of Debt

$23,000,000

Market Cap

$192,538,319

Fully Diluted Shares Out

17,233,784

Price per Share

11.17

Downside

36-38%

Source: Cliffside Research

Again we stress that this downside assumes that going forward the average income is two-times the historical average. We believe this assumption is extremely generous. The average income does take into account improved earnings post the 2011-2013 restructuring so if anything, by doubling the historical figures we are likely overestimating average future income. We doubled the average to give current management credit for margin improvements in recent years. By doubling the average historical income, we are valuing the company based on what would be the 2nd highest income in the company's history, outside of our 2016 estimate.

We believe current investors are forgetting that STS is an industrial cyclical company and should be valued as such. At the end of the day this is a maker of truck bodies and this type of business will never be exempt from business cycles and recessionary impacts. We now believe based on Q3 backlog results that 2017 earnings will likely be flat to declining from the 2016 level. Current valuation is not taking this fact into consideration. We believe that post Q3 results the stock will reset to realistic valuation near our $11.00 target. In our opinion this is an optimistic valuation.

Disclosure: I am/we are short STS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: FULL DISCLOSURE: Cliffside Research and our affiliates invest in the companies we cover. We spend great effort in our due diligence process. We make investments based on our conviction in our due diligence process. You should assume at the time of publication we hold a short position in securities of the company discussed in this report. Please see our full “Terms of Service” at cliffsideresearch.com.

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